Get With The Plan: May 29, 2011

Juliette is 27 and single, and she has two rental properties in her portfolio. She’s even thinking of adding a third property, but she’s not sure she has the time or expertise to manage it all.

“My biggest worry is where the real estate market is heading and what to do with my properties to maximize their value to me and at the very least avoid big losses,” she said, noting that she could one day go to graduate school and she’d need cash for tuition.

Juliette, whose name has been changed, has saved $14,600 in 401(k)s, $21,800 in IRAs, $16,500 in mutual funds, $16,200 in a brokerage account and $24,500 in an interest-bearing checking account. She owns two rental properties, and she lives rent-free with her parents.

The Star-Ledger asked Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton, to help Juliette analyze her real estate portfolio and what it means to her overall finances.

“I have found that people like Juliette, who have no substantial credit card debt and are saving a good percentage of gross wages, not only have come through the most recent downturn in the best shape but also stand the best chance of achieving true financial independence,” Hook says.

A review of Juliette’s cash flow shows she has approximately $15,000 in excess cash flow annually.

This number is after all expenses, taxes and 401(k) contributions.

She has equity in both of her properties despite the mortgages: $12,000 for property No. 1 and $54,000 for property No. 2. A family member lives in the first property, paying a small amount of money to help Juliette break even on the loans.

Hook says Juliette may want to re-evaluate the properties because they’re not producing any positive cash flow.

“One way to look at it is to evaluate whether the net proceeds she’d receive from selling the properties could be invested in an investment that would produce a better return than she is currently receiving,” he said. “With this type of analysis, she must be sure to include the growth potential of both the rental properties and the possible alternative investment.”

To determine the return on the $550,000 home where her family member lives, for example, she should calculate the equity ($12,000) and then calculate the return, which in this case is zero. Next Juliette should consider the expected growth rate of the property — what she expects the property value to gain, plus the build-up of equity as she pays down the mortgage.

“Let’s assume the property will grow at 4 percent per year,” he says. “Since she indicated the mortgage is interest-only, there is no buildup in equity occurring.”

Next, she should ask herself if there are other investments available that could produce returns greater than 4 percent. If Juliette thinks there is, she should consider selling and investing the proceeds.

There are other items to think about, though. Hook said the risk of an investment should be a major consideration when determining whether to stay with current investments or to make a change.

“A 4 percent return may be an acceptable return in today’s market environment if the risk of the investment is low,” Hook says. “However, if the risk of the investment is high, then 4 percent may be too low an acceptable return. This risk-return trade-off is one of the major tenets, if not the most important, of prudent investing.”

Before selling, Hook said Juliette should see if she can improve the rate of return by increasing the rent or reducing expenses.

Reducing expenses may be difficult because the mortgage rates are quite low, and variable rates most likely will rise in the future, further reducing the profitability of the rental properties.

Juliette is maxing out her 401(k), and her cash flow still shows he has $15,000 additional to save each year.

Hook recommends she fund an IRA with $5,000 a year, and put the other $10,000 in a well-diversified mutual fund portfolio.

Hook likes Roth IRAs to start because it will allow Juliette to save money that will grow tax-free, and if held for five years and beyond age 59½ it can be withdrawn tax-free.

But at some point, her income may exceed the income limit for Roth contributions, but there are some creative ways to keep the Roth going.

For example, Hook said Juliette could contribute to a traditional IRA, and then she could convert the balance to a Roth.

“There would be some taxes owed on the amount converted since she owns other IRA accounts with presumably pre-tax money in them, but it should be minimal with the benefits of the Roth IRA far exceeding the small amount of upfront taxes being paid,” he said. “She could do this procedure I call ‘contribute and convert’ each year.”